It may have taken a visiting Nobel laureate Robert Merton to get debate about the superannuation system onto a more sensible track. He recently underlined the need to focus on potential retirement income rather than accumulated lump sums.
But it’s not clear that we needed the US professor from MIT to get the ball rolling, because it’s already happening: underlying figures from SuperRatings show that more than 25% of super fund assets are in pension-paying funds (especially in retail master trusts and self managed funds).
Merton’s suggested retirement income centred not on the usual diversified portfolio used by most Australians, but on his own recipe of a mixture of annuities and deferred annuities, government bonds and reverse mortgages.
However, the annuity market here is still under-developed and government bonds are scarce and low-return. We are waiting on David Murray’s committee to report on retirement income policy, and moves to make funds report members’ potential retirement income rather than just their lump sum.
Funds have been lagging in projections of retirement income and it would require a ruling from government to make sure this was done uniformly. And nothing can disguise the fact that most current projections would produce disappointing results if it were not for the age pension safety net.
But awareness about pensions is rising and major annuity provider Challenger has just released a detailed paper on how best to approach income streams.
The paper, written by Challenger’s chairman of retirement income, Jeremy Cooper, and Wade Pfau, professor of retirement income at Byn Mawr, Pennsylvania, usefully points out that there are two different philosophies to retirement income planning: probability-based and safety-first.
The probability approach relies on simulations of investment returns to identify a portfolio with, say, a 90% chance of success; the safety first school would focus on that 10% chance of failure. The first approach uses modern portfolio theory (such as diversification) and relies on long-term returns to produce income. It can be brought undone by the timing of bad investment markets.
The second approach tries to match assets to goals to control risks and uses tools like annuities.
The paper says no one approach is wrong or right; funds and advisers need to offer retirees the approach that best suits them. It discusses alternatives at great length, ranging from safe withdrawal rates (the so-called 4% a year rule) and using “buckets” like cash, fixed interest and stocks. The ultimate is a safety first income based on an inflation-linked, immediate annuity (which, of course, depends on final savings and interest rates at retirement).
A low return rate environment
What Robert Merton’s work and the Challenger discussion paper emphasise, is that investment habits and markets in Australia make it difficult to construct retirement income projections – let alone deliver the income. The most pressing issue is low interest rates, which directly influence potential returns, especially on annuities. (Challenger annuities, with full indexation for inflation, are offering a male at 65 only 3.86% return on their capital.)
Low interest rates (and potentially lower equity market returns) also feed into account-based pensions. Over the past 10 years, rolling returns on balanced funds have run at just under 7%pa based on SuperRatings numbers. Sure, some shorter terms look better – 11%pa over three years and 8.3%pa over five years – but volatility isn’t far away, with the seven year number of 4%pa including the GFC period.
But the unspoken problem is that many Australians prefer saving outside super by investing in the capital gains tax-free family home and, increasingly, negatively-geared investment property. These are fine for accumulating wealth but awkward to unlock regular income (and may over-weight property assets).
Robert Merton and others suggest accessing these savings via reverse mortgages, which aren’t popular or widespread. Changing this would require a radical re-think – both by savers and the government, because tax incentives available for decades have distorted people’s personal investment habits.
Now, if future returns – and retirement incomes – are starting to look skinny or uncertain, and governments limit the absolute savings which can go into superannuation, pushing people into reverse mortgages for retirement income might look like a pragmatic (if unlikely) solution.
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